Betting on the Natural Gas Boom

In a U.S. economy that still hasn't recovered from the 2007–09 recession, one of the few bright spots is a boom in the production of natural gas, especially from such unlikely places as Pennsylvania. Total domestic gas production jumped 34% from 2005 to 2012, and estimated gas reserves have increased 50% in five years.

That's quite a turnaround. As recently as 2003, then Federal Reserve chairman Alan Greenspan was warning that shortfalls in domestic gas production would damage the economy, and he urged more imports as the solution. Now, the special terminals that were built for imports are being retrofitted for exports. Natural gas supports 1.7 million jobs in the U.S. today, a figure that some project will double by 2035.

The big change is the result of human ingenuity and perseverance. A Texas energy pioneer named George Mitchell, the son of Greek immigrants, experimented for more than two decades to figure out how to extract gas trapped in the Barnett Shale, around Fort Worth. He discovered a cost-effective way to combine horizontal drilling with hydraulic fracturing, or fracking, a method of stimulating shale to allow gas to escape and be captured.

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In 2003, Mitchell, now 93, became a billionaire when he sold his company to Devon Energy (symbol DVN, $54). Other large energy firms jumped into the shale business, led by ExxonMobil (XOM, $89), which bought XTO Energy in 2009 for $41 billion and became America's largest gas producer. (Prices and returns are as of April 5.)

Unfortunately, stockholders aren't sharing in the boom. For example, look at Devon, a well-run oil and gas producer with holdings throughout the U.S. and Canada. When I recommended the stock in my April 2010 column, it was trading at $67. It has dropped 19% in three years. Devon's revenues fell from $11.5 billion in 2011 to $9.5 billion in 2012, and its profits evaporated.

Devon is not alone. Shares of Chesapeake Energy (CHK, $20), another large company with interests in the Barnett formation as well as in the Marcellus Shale, in the Northeast, have been flat over the past three years. First Trust ISE-Revere Natural Gas (FCG), an exchange-traded fund with a portfolio of gas stocks, lost an annualized 0.9% during the same period.

Depressed prices. For an explanation, turn to your Economics 101 textbook. The U.S. gas supply is rising like crazy, but demand is increasing much more slowly. The result: flat and falling prices. With shale gas flowing copiously, the wellhead price of 1,000 cubic feet of natural gas fell from $6.87 at the end of 2007 to $3.35 at the end of 2012. The Energy Information Agency of the Department of Energy projects $3.51 per thousand cubic feet at year-end and $3.74 by the end of 2014. That's too low to make much money. The industry generally considers $4 as the minimum for healthy returns. Exxon­Mobil CEO Rex Tillerson, talking about natural gas prices, says, "We are all losing our shirts today."

There's an important lesson here for investors. In 1949, Benjamin Graham, Warren Buffett's mentor, wrote in his book The Intelligent Investor that it wasn't hard to see that air travel in the U.S. would blossom over the next few decades. But that didn't mean airline stocks would be profitable, said Graham. Intense competition could hold down fares. And, of course, Graham was right. Buffett, who dabbled in the stocks nonetheless, jokingly calls himself a member of "Airlines Anonymous."

But demand for gas is increasing, and that could boost profits and share prices. In the U.S., electric plants are switching from coal to natural gas, which is cleaner and generates less carbon dioxide, a key culprit in global warming. Manufacturers — especially companies, such as Dow Chemical (DOW, $31), that use natural gas to power their factories and as feedstock for making plastics and other products — are choosing to stay home rather than shift production abroad. Currently, chemical companies have started 50 construction projects valued at $40 billion to capitalize on lower gas costs.

In addition, natural gas, in compressed or liquefied form, is powering many trucks and buses, and companies such as Royal Dutch Shell (RDS-A) are betting that it will become even more important in transportation. Also, America's Northeast region may someday move from dependence on heating oil to gas, as most of the rest of the country has.

Perhaps even more important than domestic demand is foreign usage. Last year, the U.S. exported just 28 billion cubic feet of gas through liquid natural gas terminals; that's about 1.7% of our production. But experts say that LNG exports could rise to 1.5 trillion cubic feet by 2020.

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How can we be sure of demand abroad? Prices in Europe and Asia are running two, three or four times as high as in the U.S. The disparity can be attributed to the fact that, unlike oil, gas isn't easy to move. It has to be converted to a liquid, put on a ship and then converted back to a gas at port. But with prices so much higher overseas, shipping LNG can make sense.

Some U.S. manufacturers are campaigning to slow the rush to export LNG. They worry that if gas goes global, then prices at home will rise as prices abroad fall. Recent studies say that, overall, the U.S. economy will gain, but the final decision on exports lies with politicians and regulators, and the timeline is uncertain.

Shares of gas companies seem to be rising in anticipation of these changes and on news that green groups and drillers have agreed on standards that mitigate the environmental risks of fracking. Meanwhile, technological gains at many of the same companies are boosting their production of oil, which is more profitable than gas.

Examples of beneficiaries of these developments are three stocks I recommended in my 2010 column: EOG Resources (EOG, $125), with holdings in Trinidad and China as well as in Canada and the U.S.; Range Resources (RRC, $79), a standout in the Marcellus Shale; and Anadarko Petroleum (APC, $85), focused on Texas and the Rockies. Their shares are much pricier than they were in 2010, but I still like the stocks over the long haul. Another promising stock is Southwestern Energy (SWN, $37), with exposure in the Marcellus and in the Fayetteville Shale of Arkansas. All of these stocks carry high price-earnings ratios, but P/Es are not always a good measure of value for energy producers. A better measure is price to cash flow (earnings plus depreciation and other noncash charges). Using estimates from the Value Line Investment Survey, I conclude that Anadarko, at 6 times cash flow, and EOG, at 7 times cash flow, are the best deals. And I'm not giving up on Devon and Chesapeake, which are also good values.

I also like firms that provide support to natural gas explorers, including Natural Gas Services Group (NGS, $19), which analysts expect will generate 12% annual earnings growth over the next few years, and Halliburton (HAL, $39), with a P/E of 13 based on estimated 2013 earnings.

Of course, the big question is whether gas companies will end up like airlines — a boon for consumers and a bust for investors. That's always possible, but for now, it's a good bet that demand will rise — and that share prices will, too.

James K. Glassman is executive director of the George W. Bush Institute, whose recent economic-policy book is titled The 4% Solution. He owns none of the stocks mentioned.